Draghi Delivers

After much fanfare, the ECB has surprised the market.  It delivered a 10 bp cut in key rates and committed itself to a ABS/covered bond purchase scheme to start next month.  The euro sold off, dragging down other European currencies, and sparked a dramatic bond and stock rally.  

The decision to cut rates today was not unanimous.  We had anticipated it.  Our logic was linked to increasing the likelihood of a successful TLTRO launch later this month, which Draghi confirmed today.    Surveys showed an overwhelming majority did not expect a rate cut.  Draghi said, as he seemed to say in June, that interest rate policy was exhausted, and he repeated that today. 

The ECB announced that it would begin buying simple asset-backed securities and covered bonds starting next month.   The ABS will include real estate.  The details will be announced at next month's ECB meeting.  While we expected Draghi to commit to this, his announcement today went a bit further than we expected.  He indicated the ECB will buy senior tranches, and mezzanine tranches only with guarantees.  Draghi admitted that it is now difficult to assess the size of the purchases, though the press reported it could be 500 bln euros.   

As we noted previously, part of the challenges with the ABS purchases is the regulator environment.  Draghi acknowledged there had been some changes, but not enough.  Today's ECB decision may help expedite the regulatory changes.  

The staff forecasts were not very surprising. Growth was shaved by 0.1% this year and next to 0.9% and 1.6% respectively.  It was raised by 0.1% for 2016 to 1.9%.  Inflation forecast was shaved to 0.6% this year from 0.7%, but the 2015 and 2016 forecasts were unchanged at 1.1% and 1.4% respectively.    The combination of the weaker euro and base effect could see inflation bottom in September or Oct, we have argued.  

Denmark is the most likely candidate to follow the ECB in cutting rates.  Poland has also signaled it will cut rates shortly.  The Swiss National Bank is a tougher call.  Its 3-month Libor target is already at the zero bound.  It meets on September 18.  The euro had edged closer to the SNB's floor.  There has been no sign of intervention, but this would seem to be the first line of defense. 

In Jackson Hole, Draghi seemed to suggest that further efforts by the ECB needed to be coupled with efforts on fiscal policy and structural reforms.  Apparently the idea is that the deficit countries, like France and Italy needed to focus on structural reforms to boost growth while taking advantage of the flexibility provided in the Stability and Growth Pact.  The surplus countries, especially Germany, have leeway to provide more stimulus without jeopardizing their longer-term debt consolidation.